Streetwise Professor

With all the Ukraine stuff, and Gunvor, and travel, some things got lost in my spindle.  Time to catch up.

One story is this article about a debate between NASDAQ OMX’s Robert Greifeld and CME Group’s Phupinder Gill.  The “vertical silo” in which an exchange owns both an execution venue and a clearinghouse was a matter of contention:

Nasdaq OMX Group Inc. CEO Robert Greifeld was asked yesterday about the vertical silo and whether it hurts investors.

“Monopolies are great if you own one,” he said during a panel discussion at the annual Futures Industry Association conference in Boca Raton, Florida, paraphrasing a quote he recalled hearing from an investor. His exchanges don’t use this system. “We have yet to find a customer who is in favor of the vertical model,” he said.

A very retro topic here on SWP.  I blogged about it quite a bit in 2006-2007.  Despite that, it’s still a misunderstood subject 😛

Presumably Greifeld believes that eliminating the vertical silo would open up competition in execution.  Yes, there would be competition, but the outcome would likely still be a monopoly in execution given the rules in futures markets.  Under current futures market regulations, there is nothing analogous to RegNMS which effectively socializes order flow by requiring each execution venue to direct orders to any other venue displaying a better price.  Under current futures market regulations, there is no linkage between different execution venues, and no obligation to direct orders to a better priced market.  This leads traders to submit orders to the venue that they expect will be offering the best price.   In this environment, liquidity attracts liquidity, and order flow tips exclusively to a single market.

So opening up clearing would still result in a monopoly execution venue.  There would be competition to be the monopoly, but at the end of the day only one market would remain standing.  Most likely the incumbent (CME in most cases, ICE in some others.)

It is precisely the fact that competition in clearing and execution would lead to bilateral monopolies that drives the formation of a vertical silo.  This eliminates double marginalization problems and reduces the transactions costs arising from opportunism and bargaining that are inherent to bilateral monopoly situations.

Breaking up the vertical silo primarily affects who earns the monopoly rent, and in what form. These outcomes depend on how the silo is broken up.

One alternative is to require the integrated exchange to offer access to its clearinghouse on non-discriminatory terms.  In this case, the one monopoly rent theorem implies that the clearing natural monopoly could extract the entire monopoly rent via its clearing fee.  Indeed, it would have an incentive to encourage competition in execution because this would maximize the derived demand for clearing, and hence maximize the monopoly price.  (This would also allow the integrated exchange to be compensated for its investment in the creation of new contracts, a point Gill emphasizes.  In my opinion, this is a minor consideration.)

Another alternative (which seems to be what Greifeld is advocating) would be to create a utility CCP (a la DTCC) that provides clearing services at cost.  In this case, the winning execution venue will capture the monopoly rent.

To a first approximation, market users would pay the same cost to trade under either alternative. And most likely, the dominant incumbent (CME) would capture the monopoly rent, either in execution fees, or clearing fees, or a combination of the two.  Crucially, however, total costs would arguably be higher with the utility clearer-monopoly execution venue setup, due to the transactions costs associated with coordination, bargaining, and opportunism between separate clearing and execution venues.  (Unfortunately, the phrase “transactions costs” does double duty in this context.  There are the costs that traders incur to transact, and the costs of operating and governing the trading and clearing venues.)

A third alternative would be to move to a structure like that in the US equity market, with a utility clearer and a RegNMS-type socialization of order flow.  Which would result in all the integration and fragmentation nightmares that are currently the subject of so much angst in the equity world.  Do we really want to inflict that on the futures markets?

As I’ve written ad nauseum over the years, there is no Nirvana in trading market structure.  You have a choice between inefficiencies arising from monopoly, or inefficiencies arising from fragmentation.   Not an easy choice, and I don’t know the right answer.

What I do know is that the vertical silo per se is not the problem.  The silo is an economizing response to the natural monopoly tendencies in clearing and execution (when there is no obligation to direct order flow to venues displaying better prices).  The sooner we get away from assuming differently (and the Boca debate is yet another example of our failure to do so) the sooner we will have realistic discussions of the real trade-offs in trading market structure.